For over 30 years I have been tilting mirrors to reflect the economy in a different perspective from what the consensus anticipates and markets are pricing – this includes nearly 20 years of using my analysis to manage global fixed-income portfolios. My career includes econometric modeling at Data Resources Inc., creating derivatives market strategies at Salomon Brothers, managing fixed-income portfolios at OFFITBANK, and being global head of fixed-income at Lazard Asset Management. As Chief Economist of ITG IR I am in the great and unique position of being able to combine my experience with extraordinary real time information from a unique set of “big data.” To help get my career started, I earned a BA in Economics from New York University and an MA in Economics from Columbia University.

If The FOMC Is So Bullish On Growth, Why Are They So Concerned About Equities?

The headline from the FOMC minutes comes from this passage (bold face mine): “Participants also discussed whether some recent trends in financial markets might suggest that investors were not appropriately taking account of risks . . . market participants were not factoring in sufficient uncertainty about the path of the economy and monetary policy.”

“Sufficient uncertainty” is rarely about a suddently roaring economy or leaping inflation, especially since the current minutes are very much, in fact curiously focused on keeping inflation expectations from falling. We read “Some participants expressed concern about the persistence of below-trend inflation, and a couple of them suggested that the Committee may need to allow the unemployment rate to move below its longer-run normal level for a time in order keep inflation expectations anchored and return inflation to its 2 percent target . . .”

Dropping into the minutes the possibility of letting the economy run above trend “for a time” dovetails with their assessment of the employment situation “Many judged that slack remained elevated . . . . few others commented that they expected no lasting reversal of the decline in labor force participation. Several noted that a return to growth in real wages in line with productivity growth would provide welcome support for household spending.” In other words, the economy needs strong wage gains, without it real acceleration in consumption will be difficult to achieve.

There was also an interesting injection of global economic factors in regard to the inflation outlook with “. . . persistent low inflation in Europe and Japan could eventually erode inflation expectations more broadly.”

Against this backdrop of concern about prices and labor we read the FOMC’s general assessment that the economic expansion continues to tilt towards growth. “Among the factors anticipated to support the sustained economic expansion were accomodative monetary policy, diminished drag from fiscal restraint, further gains in household net worth, improving credit conditions for households and businesses, and rising employment and wages.”

With concern on inflation and employment wrapped inside optimism that the economy is steadily moving in the right direction on growth, employment, and inflation, their plan remains to end QE by October and start raising the Federal funds rate next spring. Yet, at the same time, the FOMC feels the market isn’t sufficiently pricing in downside risk. A somewhat incongruous concern considering their outlook and presumed path for policy.

Trying to square this I find this passge in Staff section of the minutes to be key (bold ours) – “The risks to the forecast for real GDP growth were viewed as tilted a little to the downside, as neither monetary policy nor fiscal policy was seen as being well positioned to help the economy withstand adverse shocks. “

These minutes, in total, seem to suggest the Fed’s real concern is extended low growth and low inflation while having little ammo left to effectively combat a decline in growth — the Fed’s nightmare scenario. It therefore follows that the sooner they can normalize policy the better. It placates hawks worried about inflation and accelerated spending and placates doves worried about what to do if all the Fed’s efforts to turn the economy turn out to be for naught. As for markets, assume the FOMC forecast dots are true. More to the point, should current quarter real growth start looking like 3% or better, the Fed is very likely to pull its scheduled increases for the Fed funds rate into this year.

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